Kass: Getting to the Core of Apple

This column originally appeared on Real Money Pro at 11:26 a.m. EST on Feb. 6.

NEW YORK ( Real Money) -- Late Monday, I started a long position in Apple ( AAPL) based principally on price -- the shares were dramatically oversold.

As the shares rose during the day yesterday, ending up by $16 a share, I sold out of the position for a profit.

Per " The Bear Case for Apple" back in September, I remain of the view that the company's profits and revenue will fail to meet consensus expectations.

That said, I wanted to share with you a brief analysis/update on Apple by Seabreeze (written by part of our research team, analysts Nick Pollari and Kelley Hopkins) that explains my continued reluctance to invest in the company.

To me, Apple's shares remain a trading sardine but not an eating sardine.

In the long-term, there are numerous factors to consider when estimating Apple's revenue going forward. Most importantly, the gap is narrowing between Apple products and competitors such as Google ( GOOG) and Microsoft ( MSFT). For example, the processor speeds, battery life and weight of the products are becoming indistinguishable and will no longer provide Apple with an advantage.

The main driver for revenue has been the Apple ecosystem -- the entire family of products and the accessories associated with the brand. Most consumers stick with the brand because you cannot easily transfer data and information onto other products. Eventually, third-party software will allow convergence between Apple products and Google's Android system and/or Microsoft Windows 8. One of Apple's key competitive advantages will be eliminated when this eventually occurs.

The consumer view on constant yearly purchases has shifted. Verizon ( VZ) has noted that given the choice between iPhones, customers are choosing the older iPhone 4 and iPhone 4S models over the iPhone 5. The choice for the older model could be based on pricing or the fact that the only major distinction between the iPhone 4 and iPhone 5 models is the larger screen on the iPhone 5.

Based on estimates from press releases, the company has opened over 400 Apple retail stores. The major increase in the stores coincided with the release of the last two revolutionary products: the iPhone and the iPad.

The increase in selling, general and administrative costs can be associated with the store launches. There is a strong positive correlation (R-squared) of 0.93 comparing store openings with SG&A costs. The company is opening more stores internationally while the domestic market is reaching a saturation point. In the U.S., the company is opening more stores in smaller markets and opening additional stores in markets where they already have a presence. The average SG&A cost per store is increasing by about 9% a year based on the company opening an average of 39 stores a year.

Revenue has increased by a compound annual growth rate of 35% from 2006 to 2012 while research and development costs increased by a CAGR of 25%. The consensus estimates have revenue growing at 12%. Our estimates, however, are closer to a CAGR of 9% given the cited factors of narrowing competitive advantage.

From 2005 to 2011 (excluding 2009), gross profit margins have ended higher than when they were reported in December (first quarter for Apple) of that year. The trend changed in 2012, when gross profit margins started the year around 44.5% and ended the year near 40%. Company guidance was for 36% gross profit margin and declining going forward.

Apple helped advance the idea of a company being successful by being both a software and hardware manufacturer. Google is advancing its Android software with its Nexus 7 tablet, and Microsoft is doing the same with new Windows software and the Surface. Microsoft is also betting on the success of its phones via its partnership with Nokia ( NOK).

Nokia has taken a beating over the years in the phone market but not without reason. Nokia is dependent on the operating systems of other software companies (Microsoft) and has had little innovation when compared to Apple. Nokia has seen little net income margin improvements and has debt on the balance sheet; Apple is debt-free with continuous innovation and improving net income margins. Apple also better manages its SG&A costs than Nokia, which leads to improving margins.

While the market continues to be optimistic on Apple's revenue and gross profit margins, as seen in the following charts, our estimates of forward earnings for Apple are still below that of the consensus.

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Unless the company is going to release a new product that implies significant innovation and (ultimately) renewed demand, we expect continued shortfalls at Apple.

At the time of publication, Kass and/or his funds had no positions in the stocks mentioned, although holdings can change at any time.

Doug Kass is the president of Seabreeze Partners Management Inc. Under no circumstances does this information represent a recommendation to buy, sell or hold any security.